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- Insurers lag other institutional investors in embracing ESG investing but several factors suggest this may be about to change.
- Most recently, the European Commission recommended that regulators make insurers incorporate climate risks into investment decisions.
- A growing body of evidence suggests that ESG investing fosters better investment decisions, performance and risk management.
- The momentum for insurers to embrace ESG investing is building.
Insurance companies are no strangers to the risks posed by weather-related events but they are now being encouraged to take a more proactive stance and incorporate environmental, as well as social and governance (ESG), criteria into their investment decision-making processes. Although they face more regulatory constraints than their pension fund peers, a variety of strategies ranging from simple exclusion to engagement and impact investing can deliver not only financial returns but also measurable sustainable outcomes.
Broadly speaking, insurers are lagging other institutional investors in adopting ESG frameworks, but several internal and external forces suggest this might be about to change. The most recent is the European Commission's high-level expert group (HLEG) report on sustainable finance, published on 31 January 2018, which took note of insurance leadership group ClimateWise's warning that "more than 4 degrees Celsius of warming this century would make the world uninsurable".
The HLEG recommended that regulators ensure insurers are taking climate risk into account not just in their annual pricing of risk, but in their longer-term investment and strategy decisions. The group called for an EU taxonomy for sustainable finance in response to widespread criticisms over the lack of clear definitions, standards and methodologies. It also highlighted the need for an increased supply of investable sustainable assets, as well as a proportionate and careful approach in disclosing climate-related factors. Last but not least, it advised that any regulatory barriers to insurers investing in long-term, zero-carbon solutions should be addressed.
Insurance Europe, the trade body for the European insurance industry, welcomed the HLEG's report, in particular the recommendations that the EU's Solvency II regulatory framework for insurers needed adjustment. The report noted that Solvency II incorrectly assumes that insurers trade all their assets and liabilities all the time, explaining that this was not consistent with either insurers' long‐term business models or policymakers' desire for them to grow their long‐term and sustainable investments.
While the trade group supports the Solvency II framework, it believes that more work is needed to ensure that the risks for long-term business are correctly identified and measured. This observation does not mean prudential regulation should be used to provide artificial incentives to green investment but that policymakers identify and remove the disincentives, for example by recognising the important difference between short-term and long-term investment risks.
There are also debates in the industry about whether regulators should increase capital requirements for insurers that do not comply with any forthcoming ESG-related (especially climate-related) guidance.
Speaking in 2015, Bank of England Governor, Mark Carney, conveyed a similar message to the HLEG report, stating that insurers should stress test the effect of environmental disasters on their finances and minimise the contribution of their portfolios to man-made climate change.
The environment though should not be the only focus. Although an important component, social and governance factors are just as critical to the investment decision-making process. Insurers should raise red flags, for example, on those companies that fail to protect their workers and the communities they operate in. This ranges from human rights abuses to gender inequality, child labour, poor health and safety as well as supply chain practices. The same guiding principles should also apply to organisations who do not have robust governance frameworks in place that ensure among other things transparency, industry standards, codes of conduct and engagement with shareholders.
ESG investing solutions
As with any investment strategy, the first question insurers should ask is what their drivers and objectives are. There are no one-size-fits-all solutions and, currently, they have to be crafted within the Solvency II capital requirement confines. The learning curve may be steep but insurers have an advantage in that risk is their bread and butter. For example, they are experts at risk modelling and risk pricing for natural catastrophe insurance, as well as assessing social and health issues for medical insurance and annuities.
A few asset managers such as Columbia Threadneedle Investments offer a one-stop-shop for the different building blocks, as well as education in developing a Responsible Investment strategy. In the past, a starting point would have been devising an exclusion list which eliminates companies that conflict with ethical or norm-based values. However, increasingly, investors are integrating ESG factors and performance alongside well-established financial criteria, such as cashflow and P/E metrics, because doing so is seen to lead to better investment decisions, performance and risk management.
One investment approach is impact investing or outcome-based strategies which generate a measurable environmental and/or social impact as well as a financial return. One popular way to gain access is through green bonds, which have existed for the past ten years but have been bolstered by standards such as the Green Bond Principles, created at the beginning of 2014 by a group of investment banks. Research from Moody's Investor Services shows that global green bonds issuance is set to grow by around 60% to $250 bn (£181bn) this year.
Social bonds, albeit a much smaller part of the market, are also increasingly gaining traction. The first half of 2017 saw issuance more than double to over $4.5 bn, up from $2 bn for the whole of 2016, according to figures from DLA Piper. To date, Dutch state-owned bank NWB issued the largest social bond last May, raising $2.2 billion to lend to affordable housing initiatives – although they can encompass a much wider area. Guidelines published last year by the International Capital Market Association list several examples including: providing basic infrastructure; access to healthcare, education, vocational training, financing, and financial services; employment generation; food security; and socioeconomic advancement and empowerment.
Growing momentum
With a long history of Responsible Investment investing, Columbia Threadneedle Investments has been at the forefront of mainstream impact investment, having partnered with Big Issue Invest four years ago to launch the Threadneedle UK Social Bond Fund, the first mainstream social investment fund in the UK. Investments have included supporting Manchester University building a new cancer research unit, which also created jobs in the local area, and helping Cardiff University to fund an innovation campus.
Separately, Columbia Threadneedle Investments has invested in green bonds issued by the European Investment Bank (EIB) and Banque Federative du Credit Mutuel, which are targeted towards renewable energy and energy efficiency, as well as Banque Federative du Credit Mutuel (BFCM) bonds that focus on social enhancement through training and employment in the provinces where BFCM operates.
If the recent past is anything to go by, the reasons for insurers to join other institutions and embrace ESG investing will only grow. Insurers have much to gain from extending their understanding of environmental risks to embracing the full range of ESG factors in their investment strategies.
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